Anticipating rising volatility

Option premiums ruled high as the market seemed braced for a bout of post-Budget volatility. There was also a dwindling of open interest that suggested caution on the part of traders.

In the past 30-odd trading sessions, the Nifty has been generating average high-low swings of 3.3 per cent per day – that translates to around 150 points at current prices. This is actually lower than its long-term high-low swing of around 3.7 per cent in the past 250-odd sessions.

However, despite acceptable historical volatility, near-month option premiums have spiked. A rise in premiums equals a rise in implied volatility, which can only be explained as a sign that traders expect spot volatility to rise in the near future.

The Nifty has been stuck in a trading range for around 10-12 sessions, moving between 4,150-4,450. A breakout could cause a swing of 300 points (the width of the trading range) and hence, target either 3,850 or 4,750. A trader would think of that as equivalent to two successive trending sessions.

Direction is likely to be determined by the Budget and the market’s reaction. Historically, post-Budget movements do involve higher-than-normal volatility and there is a lot riding on this Budget because it signals the intentions of a new government.

There is some indication that regular market participants anticipate a continued correction. First of all, there has been a distinct loss of trading volume. Second, there has been a substantial cut-back in open interest. Third, the put-call ratio for August and September options is bearish. Hedge ratios have been high – another sign that the market consensus is negative. None of this is conclusive – a well-received Budget could alter sentiment in one session - but it is indicative of caution.

Although both the subsidiary indices have seen dwindling option interest (OI), they are liable to continue normal behaviour patterns. The CNXIT remains reverse-correlated to the rupee, while the Bank Nifty remains highly correlated to the Nifty. Since the rupee usually strengthens, and the market usually rises when FIIs invest heavily, this means the CNXIT could be a decent hedge. The Bank Nifty on the other hand, remains a high-beta play on the Nifty direction.

The put-call ratio is puzzling. In terms of OI, the July Nifty PCR is at 1.1, which is neutral or slightly bullish. The August -September PCR is at 0.8, which is very bearish. The overall PCR is around 0.99 which is on the bearish side of neutral. Around 68 per cent of OI is in the July series, which is slightly higher than normal.

Among relatively near-the-money long-term options, the December 2009 3,700p (182) has quite a lot of volume. So does the December 2009 3,800c (820). The break-evens for these contracts are around 3,520 for the put and 4,620 for the call. In the past six months, the market has actually swung between a low of 2,539 (March) and a high of 4,693 (June).

In a situation of anticipated high volatility, with high option premiums, the trader should plan very carefully. It is dangerous to sell naked options near the money. The high premiums make this tempting but the potential for loss is great. An option trader should ideally not consider un-hedged positions at all – look for covered positions and spreads. A futures trader should set tight stop losses.

Close to money (CTM) premiums are too high to make naked positions attractive. Spreads CTM offer reasonable risk-reward ratios. The CTM bullspread of long 4,500c (178) and short 4,600c (138) costs 40 and pays a maximum of 60 while the CTM bearspread of long 4,400p (202.5) and short 4,300p (160.5) costs 42 and pays a maximum of 58. Either spread could be worth taking and there’s little to choose between them.

Due to the high premiums, strangles CTM are very expensive. A long 4,200p (125) and a long 4,600c (138) costs 262 and this is roughly 200 points from the money. It would be profitable only if the market moves beyond 3,937 or 4,862. It can be offset by selling the 5,000c (38) and the 3,800p (38.5). That combined long-short strangle position costs 186 and offers profits if the market moves beyond 4,014 or 4,786. It would require an extraordinarily good or poor Budget to induce this large a swing in the next three weeks. So the strangles don’t seem to be really worthwhile.

If you wish to create two-way positions, the most practical is to take a futures position in your preferred direction and hedge with an option spread in the opposite direction. That is, take a long futures position coupled to a bearspread if you’re bullish and vice-versa. If you opt for this sort of future plus spread positions, make sure that there is a tight stop loss on the future. This sort of position will only work if there is a big swing.

STOCK FUTURES/ OPTIONS Hedge ratios are high, which means that there is a big focus on overall market direction. But there is also the usual pre-Budget jockeying for speculative positions in sectors that could receive sops. Most of the focus is in infrastructure-related sectors and in fertilisers. ONGC is seeing some bullishness due to rising crude prices. If there is some sort of petro-price decontrol, PSU refiners would be beneficiaries. Steel scrips have witnessed activity on advisories that domestic consumption will grow in the current fiscal. There is a lot of action in the power sector. One interesting possibility is a long position in Suzlon Energy. The stock has seen a sharp correction and it could be set for another upmove.